Given the fear of future tax increases, why aren’t more federal employees utilizing the Roth TSP to provide a buffer from future taxes?

I ask this question all the time during workshops and individual sessions with federal employees. The most popular responses are: (1) I don’t understand how the Roth TSP works, (2) I will be in a lower tax bracket in retirement, and (3) I don’t like the withdrawal limitations of the Roth TSP.

If you would like to get a better understanding of how the Roth TSP works, click here to request Chapter 5: The Roth TSP, from my book: FedSavvy, Tools and Tips to Maximize Your Federal Benefits.

If you really think you are going to be paying less in taxes at retirement, you may want to rethink that.

First of all, the federal government has excessively underfunded liabilities in Social Security and Medicare due to changing demographics. In addition, tax rates are historically low over the past twenty-five years. Combining low tax rates and huge deficits are a lethal combination that is driving our deficit to dangerous levels.

In order to reduce the deficit and fix entitlement programs, our government is going to have to bring in more revenue which likely means higher taxes. And, if you still think you are going to be in a lower tax bracket in retirement, keep in mind most retirees lose the lion’s share of their deductions in retirement, with the two biggest being mortgage interest and their kids. To request a copy of the booklet “Tax Planning in Today’s Economic Environment,” click here.

The benefit of contributing to the Roth TSP allows you to pay taxes at today’s known tax rates on your contributions only as opposed to paying taxes on your contribution and earnings at an unknown tax rate.

Unlike a Roth IRA, there are no income limits with the Roth TSP. Anyone that is eligible to contribute to the TSP is eligible to contribute to the Roth TSP. And you can contribute significantly more to the Roth TSP (For 2016 – $18,000, plus $6,000 if age 50 or over) than a Roth IRA (For 2016 – $5,500, plus $1,000 if age 50 or older).

The Roth TSP is a great accumulation vehicle but is lacking on the distribution side. All distributions come out proportionately from the traditional TSP and the Roth TSP.

The real benefit of the Roth is to maximize tax free income. In a Roth IRA, there are no required minimum distributions (RMD’s) unlike the Roth TSP, which requires you to take out a RMD beginning at age 70 ½ (unless you are still working as a federal employee). You are essentially forced to distribute your Roth TSP account at the same time you are distributing your taxable traditional TSP account.

Most financial experts recommend that you delay taking withdrawals as long as possible to allow your Roth IRA to grow into a tax-free harvest. This is not possible with the Roth TSP, nor is the ability to manage tax brackets in retirement.

Let’s walk through an example of this using IRA accounts.

Tony is withdrawing $2,000 a month from his IRA. He has been doing this since the beginning of the year and if he continues past September it will bump him up to the next tax bracket. He needs the income to pay his expenses so he simply stops taking distributions from his IRA for the remainder of the year and takes the distributions from his Roth IRA, which are not taxable.

Unfortunately, the TSP does not allow you to ever take distributions separately from traditional TSP and Roth TSP. The only way to separate your TSP taxable and tax-free distributions is to roll your traditional TSP to an IRA and your Roth TSP to a Roth IRA.

The Roth IRA on the distribution side is much friendlier than the Roth TSP, but the TSP will not allow you to just rollover the Roth portion. However, it appears that there is a way to keep your traditional TSP funds at the TSP and move your Roth TSP to a Roth IRA.

“The Back Door Roth TSP Withdrawal” is a slightly complicated way to separate your traditional TSP and your Roth TSP without losing the ability to keep your traditional TSP monies in the TSP.

Below are the steps for this transition. For simplicity purposes, the example below assumes no gains or losses in the accounts during the process. Before embarking on this, make sure you understand the steps thoroughly because some of the steps are irrevocable.

Step 1

Open up a traditional IRA and a Roth IRA in anticipation of a partial rollover from TSP. Do a partial withdrawal of most of your TSP. The TSP requires you to keep at least $200 to maintain an account. (I would recommend leaving more than $200 just to avoid a mix-up).

Example

Lisa is retired and has $400,000 in her combined traditional and Roth TSP. The Roth balance is $100,000 and the traditional balance is $300,000. She does a partial withdrawal of $399,000. She will leave behind $1,000 which will be split pro-rata in the same proportion before the rollover (25% Roth TSP/75% traditional TSP). Lisa indicates on the TSP-77 that she wants 100% of her traditional TSP to transfer into her traditional IRA and 100% of her Roth TSP to transfer into her Roth IRA. She will be transferring $99,750 to her Roth IRA (25% of $399,000) and $299,250 to her traditional IRA (75% of $399,000).

Step 2

Once your IRA and Roth IRA receive your funds, you can now transfer your Traditional IRA back to TSP.

Example

Once Lisa’s funds have settled in her Traditional IRA, she completes TSP-60 to transfer her IRA back into TSP. Her IRA custodian must complete Section II of the TSP-60 certifying that the funds are coming from an eligible retirement plan. Once the funds are moved back into TSP Lisa will have $300,000 in the traditional TSP and $250 in the Roth TSP.

The net result was that Lisa transferred 99.8% of her Roth TSP into her Roth IRA, while leaving all of the traditional TSP in the TSP.

About the Author

Carol Schmidlin, Certified Financial Fiduciary®, MRFC® is the President of Franklin Planning and has been advising clients on how to grow and preserve their wealth for 25 years. In addition to her financial planning practice, she is the founder of FedSavvy® Educational Solutions, which provides Financial and Retirement Literacy Programs for Federal Employees. She is passionate about helping families with all phases of Wealth Management and is a member of Ed Slott’s Master Elite IRA Advisor Group. Her practice maintains a home office in Sewell, NJ along with a satellite office in Washington, DC. Carol can be reached at (856) 401-1101.